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# Cutting edge l Interest rates

## Back to the future

Current developments in exotic interest rate products push the demand for more sophisticated
interest rate models. Here, Jesper Andreasen presents a new class of stochastic volatility multi-
factor yield curve models enabling quick calibration and efficient Monte Carlo simulation

## rable in the sense that there exist a deterministic vector function g on Rk

I
n the early 1990s, Cheyette (1992) and others introduced a separable
volatility specification of the general Heath-Jarrow-Morton (HJM, 1992) and a matrix process h on Rk × k, so that:
σ (t , T )′ = g (T )′ h (t )
model. Contrary to general HJM and Libor market models, this specifi-
(2)
cation allows for Markov representation of the full yield curve in a low
number of state variables. In this article, we present a class of separable then a Markov representation of the dynamics of the yield curve, involv-
volatility structure yield curve models that incorporates stochastic volatili- ing k + k × (k + 1)/2 state variables, emerges.
ty to match the volatility smile as observed in the vanilla interest rate op- Without loss of generality, the model can in this case be formulated as:
tions markets. We combine this with recent ideas for approximation of
stochastic volatility models with time-dependent parameters by Piterbarg ( )
dX (t ) = Y (t ) ι − I κ (t ) X (t ) dt + η (t ) dW (t ) , X (0) = 0
(2005a-b) to yield a fast and efficient calibration of the model.  
The first sections of the article consider separable volatility structures dY (t ) =  η (t ) η (t )′ − I κ (t )Y (t ) − Y (t ) I κ (t )  dt , Y (0) = 0
 
in HJM models and stochastic volatility models for vanilla swaptions and
P (0, T ) − G (t ,T )′ X (t ) − 12 G (t ,T )′ Y (t )G (t ,T )
caps. We then introduce our model specification and describe how cap P (t , T ) = e
and swaption prices can be approximated in the model. Calibration tech- P (0, t )
niques and numerical examples are considered. The final sections of the
 − T κ (u )du − κ (u ) du 
T ′
G (t , T ) = ∫ g (t , s ) ds, g (t , T ) =  e ∫t 1 ,..., e ∫t k
article consider pricing in our model by Monte Carlo simulations and the T

## Separable volatility ι = (1,...,1)′ , X , G , g , κ ,W ∈  k , (3)

If P(t, T) denotes the time t price of a zero-coupon bond maturing at time Y , η ∈  k × k , I a = diag ( a1,…, ak ) ∈  k × k
T, the time t continuously compounded forward rate for deposits over the
interval [T, T + dT] is given by: In the context of the separable formulation (2) we have:
∂ ln P (t , T ) g (T ) = g (0, T ) , h (t ) = I g−(1t ) η (t )
f (t , T ) = −
∂T The first k state variables, the elements of X, can be interpreted as yield
Heath, Jarrow & Morton (1992) show that any arbitrage-free term structure curve factors that pertubate the forward curve and are directly associated
model with continuous evolution of the yield curve has to satisfy: with the driving Brownian motions, whereas the remaining k × (k + 1)/2

## (∫ σ (t, s) ds) dt + σ (t,T )′ dW (t )

state variables, the elements of the symmetric matrix Y, can be seen as ‘con-
df (t , T ) = σ (t , T )′
T
(1) vexity’ terms that have to be carried along to keep the model arbitrage free.
t
For k = 1 and η deterministic, Y becomes deterministic and we obtain
where W is a vector Brownian motion under the risk-neutral measure and the general Gaussian model, that is, a Vasicek (1977) model with time-de-
{σ(t, T)}t ≤ T is a family of vector processes. pendent parameters. This led Jamshidian (1991) and Babbs (1993) to de-
The HJM approach prescribes a very straightforward way of specifying note the separable volatility specification as, respectively, ‘quasi’ and
an arbitrage-free term structure model that automatically fits the initial term ‘pseudo’ Gaussian models.
structure: all one needs to do is to specify the forward rate volatility struc- The potential computational saving in using this type of model rather
ture {σ(t, T)}t ≤ T. than the general HJM approach is considerable. For example, if we con-
However, the problem with this modelling approach is that the re- sider the case of pricing a 30-year structure with quarterly fixings and pay-
sulting model is not generally Markovian in a limited number of state vari- ments by simulation, the general HJM or Libor market model (LMM)
ables. In general, the HJM model approach requires us to use the full approach will require the evolution of at least 120 points on the yield curve,
forward curve as a state variable to close (1) as a Markov system. This is whereas a four-factor version of the separable model requires the evolu-
independent of the dimension of the driving Brownian motion and it is tion of a maximum of 14 state variables.
even the case if the forward rate volatility structure is deterministic. So For the one-dimensional case, k = 1, a finite difference solution is vi-
when we simulate the model (1) we generally need to carry forward all able and is most often a more efficient numerical solution method than
points on the forward curve. Hence, the computational effort of simula- Monte Carlo simulation. We will discuss this later. Finite difference solu-
tion of the model (1) grows at a quadratic rate in the time horizon. Sim- tion of simpler versions of the model are also considered in Andreasen
ilarly, if we attempt to approximate the process (1) with a discrete process, (2000) and Andersen & Andreasen (2002).
the resulting tree will be non-recombining and thus have a number of It is worth noting that if we let κ1, ... , κk be constants, then:
nodes that grow at an exponential rate in the number of time steps, or k
the time horizon. σ (t , t + τ )′ = ∑ e − κ i τ ηi (t ) → ∫ e − κτ ηκ (t ) d κ
However, Cheyette (1992), Babbs (1993), Jamshidian (1991) and i =1

Ritchken & Sankarasubramaniam (1993) independently find that if we re- for k → ∞ and an appropriately chosen sequence κ1, κ2, .... So the model
strict ourselves to a volatility structure for the forward rates that are sepa- (3) can be seen as a representation of the forward rate volatility structure

## 104 RISK SEPTEMBER 2005 ● WWW.RISK.NET

on a (discrete) basis of exponential functions. The function κ |→ ηκ(t) can A. Skew and smile parameters fitted to euro
thus be viewed as the inverse Laplace transform of the forward rate volatil- cap and swaption prices
ity structure in the tenor dimension: t |→ σ(t, t + τ).
m 6m 1y 2y 5y 10y 15y 20y 30y
Stochastic volatility processes 6m 0.75 0.75 0.62 0.50 0.44 0.38 0.34 0.29
The most popular stochastic volatility model for caps and swaptions appears 1y 0.75 0.65 0.55 0.46 0.38 0.32 0.30 0.27
to be the SABR model by Hagan et al (2002) where the volatility is specified 3y 0.68 0.58 0.49 0.37 0.31 0.26 0.25 0.22
as a geometric Brownian motion that has some correlation with the under- 5y 0.65 0.52 0.43 0.32 0.27 0.23 0.21 0.17
10y 0.58 0.45 0.38 0.27 0.23 0.21 0.17 0.14
lying forward swap rate. This model is quite difficult to work with in the
15y 0.48 0.36 0.31 0.26 0.20 0.18 0.15 0.13
context of full yield curve models, for a number of reasons. ε 6m 1y 2y 5y 10y 15y 20y 30y
First, the SABR model does not incorporate mean-reversion in volatili- 6m 1.15 1.13 1.13 1.18 1.29 1.29 1.30 1.27
ty, which means that when the model is fitted to observed cap and swap- 1y 1.15 1.01 1.05 1.06 1.11 1.14 1.13 1.12
tion prices the implied volatility of volatility parameter most often turns 3y 1.05 0.93 0.91 0.93 0.94 0.93 0.94 0.93
out to be decreasing with the expiry of the underlying option. This in turn 5y 0.95 0.88 0.88 0.86 0.85 0.86 0.86 0.85
implies that a full dynamic version of the SABR model would have to ex- 10y 0.86 0.89 0.89 0.87 0.84 0.84 0.84 0.83
15y 1.03 1.00 0.97 0.94 0.91 0.90 0.91 0.89
hibit even steeper decreasing forward volatility of volatility. Second, in
many implementations of the SABR model the correlation between volatil- Note: this table reports best fit m and ε parameters to observed cap and
ity and underlying rate are quite different for different expiries and tenors. swaption prices for β = 0.05. Expiries are in the rows and tenors are in the
Non-zero correlation is technically quite difficult to handle in a full yield columns. The currency is the euro and the parameters were estimated
curve model and potentially time-varying correlation is of course even from Totem consensus prices for the end of a particular month in 2004
more complicated. Third, as the SABR model has no closed-form for Eu-
ropean-style option prices, it is typically implemented for European op-
tion pricing by expansion techniques whose accuracy deteriorates for 1. This and last month’s models against
longer expiries. This may have limited practical importance if the SABR Totem quotes
model is only used for European-style option pricing, but our scope is to
price general path-dependent instruments, so we need our European-style 1.0
option pricing to be consistent with the actual specified dynamics. mdl(t – 1m)
0.8 mdl(t)
model as our basis for developing a full yield curve model with stochas- 0.6
tic volatility: 0.4
dS (t ) = λ z (t )  mS (t ) + (1 − m ) S (0) dW1A (t ) 0.2

( )
dz (t ) = β 1 − z (t ) dt + ε z (t ) dW2A (t )
%

0.0
(4) 0% 20% 40% 60% 80% 100%
–0.2
–0.4
where WA is a Brownian motion under annuity measure, that is, the mar-
tingale measure with the annuity: –0.6
n –0.8
A (t ) = ∑ δ i P (t , ti )
i =1 –1.0

δi = ti – ti – 1 is the day count fraction, S(t) = (P(t, t0) – P(t, tn))/A(t) is the for- This figure shows the deviations from Totem consensus quotes for
ward par swap rate under consideration, and all the parameters λ, m, ε, β euro swaptions in terms of implied Black volatility for two models. One
that had its m, ε parameters fitted the month before the other had its
are constants. The swap rate is a martingale under the annuity measure.
parameters fitted this month. Expiries range from six months to 20
In terms of the implied Black-Scholes volatility smile, the level is con- years, tenors from one year to 30 years, and strikes from 5% to 95%
trolled by λ. As correlation between the swap rate and the volatility is as- in Black-Scholes delta terms – all in all, 912 swaptions. All data is as
sumed to be zero, the slope of the smile is fully controlled by the m of a particular end of month in 2004
parameter. The smile becomes increasingly negatively sloped as m is de-
creased. Subnormal skews, corresponding to m < 0, are possible with the
note of caution that S is restricted from above by 1 m– m S(0) when m is neg- In our experience, the implied skew and smile parameters m and ε are
ative. Increasing the volatility of local variance, ε, increases the curvature quite stable over time, so in practice only the volatility level parameter λ
of the smile. Increasing the speed of mean-reversion, β, increases the rate needs to be updated on a regular basis, say daily or weekly. To illustrate
at which the curvature of the smile decays with expiry. this, figure 1 shows the deviations in terms of implied Black volatility from
The model is essentially a ‘shifted’ Heston (1993) model, so it allows end-of-month Totem1 consensus quotes for euro swaptions for strikes rang-
for an analytic solution based on numerical inversion of the Fourier trans- ing from 5–95% delta, for two different models (4). The first model had its
form. Lipton (2002) and Lewis (2000) give representations of the option m and ε grids fitted the month before whereas the second was fitted on
price that avoid the numerical instability of the representation in the orig- the particular date. In both cases we set the λ so that the model fits the at-
inal Heston (1993) paper. the-money Totem levels. Expiries range from six months to 20 years and
This model gives a good fit to observed cap and swaption prices with tenors from one year to 30 years. In total, 912 swaptions were priced. We
reasonably stable parameters across expiries and tenors. An example of see that both models for the most part agree with the Totem consensus
the fitted m, ε parameters is given in table A. We note that the model’s quotes within +/–0.25% in Black-Scholes implied volatility for all strikes.
volatility of variance parameter, ε, is related to lognormal volatility of volatil- Figure 2 gives a further indication of the stability of the skew and smile
ity by the approximate relation: parameters of the model by showing the evolution of monthly calibrated
1
lognormal volatility of volatility ≈ ε / 2 Totem provides independent mark verification services for interbank options based on
mid-market quotes from approximately 20 leading option dealers

## WWW.RISK.NET ● SEPTEMBER 2005 RISK 105

Cutting edge l Interest rates

2. Time-series evolution of calibrated m, ε Here the matrix product RR′ is the instantaneous correlation matrix for the
parameters k forward rates.
Under the separable volatility specification in (3), we have:
dF (t ) = Γ (t ) η (t ) dW (t ) + O(dt )
1.0
 ′
0.8  g (t , t + τ ) 
Γ (t ) =    ∈ k ×k (7)
 
 
 g (t , t + τ k ) 
0.6 ′
m
Legend?

## 0.4 eps Equating diffusion terms of (6) and (7) yields:

0.2
 ( )
Γ (t ) η (t ) = z (t )  I M (t ) I F (t ) + I − I M (t ) I F (0)  I λ (t ) R (t )


0 (7a)

–0.2
1 3 5 7 9 11 13 15 17 19 21 23 25 −1
 ( )
η (t ) = z (t )Γ (t )  I M (t ) I F (t ) + I − I M (t ) I F (0)  I λ (t ) R (t )


This figure shows the evolution of the monthly calibrated 10-year by with:
10-year skew and smile parameters m, ε over the period 2003–05.
The currency is the euro ( )
dz (t ) = β 1 − z (t ) dt + ε (t ) z (t )dZ (t ) , dZdW = 0 (7b)
The volatility specification (7) in combination with (3) defines our model.
In most cases we choose constant κ1, ... , κk as well as a constant cor-
m and ε for the 10-year × 10-year euro swaption over 2003–05. Though relation structure RR′. The latter is typically estimated from the historical
the implied skew parameter m increases over the period, the implied volatil- time-series data of the yield curve. In this case, the model parameters that
ity of variance ε is more or less constant over the period and both time se- need to be set by calibration to swaption and cap prices are:
ries exhibit low volatility. ■ The forward rate volatility structure, λ for all times t and the tenors
τ1, ... , τk.
Model specification ■ The forward rate skew structure, m for all times t and the tenors
Andersen & Andreasen (2002) suggest a Libor market model with stochastic τ1, ... , τk.
volatility, which is extended by Piterbarg (2003) to allow for a time- and ■ The forward volatility of volatility, ε for all times t.
tenor-dependent local volatility skew parameter. The motivation for this is In terms of the implied Black-Scholes volatility smiles for swaptions and
that if we consider implied parameters of the model (4), as in table A, we caplets, the first parameter controls the absolute level, the second the slope
typically see that the skew parameter m is fairly constant across expiry but (skew) and the third the curvature (smile).
it tends to decrease with tenor. On the other hand, the implied ε parame- We see that the model, at least in principle, can exactly fit the volatili-
ter appears to be fairly constant across both expiry as well as tenor, at least ty level and slope for all expiries along k tenors, whereas the curvature
for expiries over one year. can only be fitted exactly for one tenor. In practice, though, our calibra-
If we use continuously compounded rates rather than discrete rates as tion will most often be on a best fit basis.
model primitives, the Piterbarg model can be formulated as: For the one-factor case, k = 1, we do, however, often choose to go for

( )
an exact fit to a specific strip of swaptions or caplets. In this case we often
df (t , T ) = z (t , T )  m (t , T ) f (t ) + 1 − m (t , T ) f (0, T ) specify the model a bit differently, namely:
× λ (t , T ) ρ (t , T )′ dW (t ) + O ( dt ) ( )
η (t ) = z (t )  m (t ) S (t ) + 1 − m (t ) S (0) λ (t ) (8)

( ( ))
dz (t ) = β 1 − z 1 − z (t ) dt + z (t )ε (t ) dZ (t ) where λ, m are now scalar functions of time and S is a par swap rate re-
ferring to different swap periods over the time horizon. For example, if we
λ (t , T ) ∈  , ρ ( t , T ) ∈  k , ρ ( t , T ) = 1 (5)
choose to fit the model to the strip of 1×29, 2×28, … , 29×1 swaption
Z (t ) ∈ , dZ (t ) dW (t ) = 0 smiles, we let S be the 1×29 par swap rate for times between year zero
and one, 2×28 par swap rate for times between year one and two, up to
where m, λ and ρ are deterministic functions of time and maturity, ε is 29×1 par swap rate for times between year 28 and 29.
a deterministic function of time and β is a constant. We note that m = 0
corresponds to a normal model whereas m = 1 corresponds to a log- Swaption pricing
normal model. For efficient calibration of the model, closed-form pricing of caps and swap-
Fix k tenors τ1, ... , τk. For the corresponding forward rates we have: tions is essential. In this section, we describe an accurate (near) closed-
form approximation.
 ( )
dF (t ) = z (t )  I M (t ) I F (t ) + I − I M (t ) I F (0)  I λ (t ) R (t ) dW (t ) + O ( dt )
 Using Itô’s lemma and the fact that the swap rate S is a martingale under
the annuity measure, we get:
( )
F (t ) = f (t , t + τ1 ) ,…, f (t , t + τ n ) ′ ∈  k dS (t ) = S (t )′ η (t ) dW A (t )
X (9)

M (t ) = ( m (t , t + τ ) ,…, m (t , t + τ ))′ ∈ 
1 n
k where we let subscripts denote partial derivatives, that is, SX = (∂S/∂X1, ...
, ∂S/∂Xk). Given fixed mean-reversion coefficients κ1, ... , κk this derivative
I ( ) = Diag (λ (t , t + τ ) ,…, λ (t , t + τ )) ∈ 
λt 1 n
k ×k
can be calculated in closed form by combining (7) with the bond price
(6)
formula in (3).
 
R (t ) =  ρ (t , t + τ1 )′ ;…; ρ (t , t + τ1 )′  ∈  k × k Our approximation goes in two steps:
 
■ A. Approximate the stochastic differential equation (9) by the model:

## 106 RISK SEPTEMBER 2005 ● WWW.RISK.NET

()
dS t = () ( ) ( ) ( ( )) ( )
z t λ (t )  m t S t + 1 − m t S 0  dW1 t

A
() here for space considerations, but the main point is that the technique is
both very quick and accurate. Computationally, the method relies on a nu-
(10)
dz (t ) = β (1 − z (t )) dt + ε (t ) z (t ) dW2 (t ) merical solution of one Ricatti ordinary differential equation per swaption
A

## pricing -- all remaining calculations are done in closed form. Compared

where all parameters are time-dependent. with a direct solution of (10) by numerical inversion of Fourier transform
■ B. Approximate the stochastic differential eqaution (10) by the time-ho- as suggested in Andersen & Andreasen (2002), this technique is much faster
mogeneous model: and only marginally less accurate.
d S (t ) = z (t ) λ  mS

  (t ) + 1 − m
(
 (t ) S (0) dW A (t )
 1 ) Calibration
(11)
( )
d z (t ) = β 1 − z (t ) dt + ε z (t )dW2A (t )
We start by fixing κ1, ... , κk, the correlation structure for the forward rates
RR′, and a set of tenors τ1, ... , τk of the model. We further fix a time grid
where all parameters are constant. 0 = t0 < t1 < ... of expiries and a set of tenors {Tj} corresponding to the
Approximation
_ _ A essentially involves finding time-dependent parame- swaption smiles that we wish to calibrate the model to. We assume that
~ ~ ~
ters λ, m so that the diffusion in (9) is approximated by the diffusion in we have fitted parameters λ hj, m hj, ε hj of the model (4) for these expiries
(10), that is: (h) and tenors (j) of the calibration swaptions, as in table A.
2 We let the model (3) and (7) be parameterised by:
zλ 2  mS + (1 − m ) S (0) ≈ S X ′ η
2
λ (t , t + τi ) = λ hi , m (t , t + τi ) = mhi , ε (t ) = ε h
(12)

Equating levels in (12) at X(t) = Y(t) = 0 yields: for th – 1 < t ≤ th. We use approximation A and B to give us constant para-
~ ~ ~
1
2 meters λ hj, m hj, ε hj for each swaption. We now calibrate the model by boot-
λ (t ) = S X (t )′ Γ (t ) I F (0) I λ R
2 −1
(13) strapping, that is, we solve the optimisation problems:
S (0)
2
X = 0, Y = 0

( ) ( ) ( )
2 2 2
Differentiating (12) with respect to Xi at X(t) = Y(t) = 0 yields: min γ λ ∑ λ hj − λ hj  hj − m
+ γm∑ m hj + γ ε ∑ ε hj − ε hj
{λ hi , mhi , ε h }i =1,…,k j j j

(λ (t ) S (0) S )  1 ∂ 2
2
(t ) X =Y = 0 m (t ) =  S X (t )′ η (t )  sequentially for h = 1, 2, .... Here γl, γm, γε are weights for balancing the dif-
 z (t ) ∂X i
Xi (14)
 X = 0,Y = 0 ferent objectives against each other. Most often we calibrate the model in
a sequence where only one of the weights γl, γm, γε is non-zero at the time.
for i = 1, ... , k. Due to the form of η, the right-hand_side of (14) is inde- As an example of this, consider simultaneous calibration of a four-fac-
pendent of z(t), so (14) forms k linear equations in m. We solve these by tor model of the type specified in (3) and (7) to all the euro cap and swap-
regression: tion implied volatility smiles of 19 expiries ranging from six months to 20
 2 years and eight tenors ranging from six months to 30 years. The implied
k

∑  S X (t ) ∂ X z (t ) S X (t )′ η (t ) 
−1
volatility smiles are parameterised by the parameters in table A. We set:
i =1   X = 0,Y = 0 (κ1, κ 2 , κ 3 , κ 4 ) = (0.015, 0.15, 0.30,1.20)
i
 i
m (t ) = (15)
(τ1, τ 2 , τ3 , τ 4 ) = (6m, 2 y,10 y,30 y )
k
λ (t ) S (0) ∑  S X i (t ) 
2 2

i =1
  X = 0,Y = 0
and use a correlation matrix estimated for historical time-series data of for-
All quantities in (13) and (15) can be calculated in closed form using the ward rate curves.
zero-coupon bond price formula in (3). The resulting model parameters are shown in table B. We see that the
It should be noted that this approximation can be slightly refined by forward skew parameters, mi, are decreasing more sharply in tenor than
evaluating (13) and (15) along levels of X, Y corresponding to approxi- the corresponding ‘term’ skew parameters shown in table A. This is con-
mate expected levels of X, Y under the annuity measure of the swaption sistent with the findings in Piterbarg (2003). There does not appear to be
under consideration. a clear trend over time in any of the calibrated parameters. However, there
Approximation B involves finding constant parameters so that the model is more noise in the calibrated forward skew parameters than in the Piter-
(11) produces option prices that are close to those of (10) with parame- barg (2003) case. This is probably due to the fact that we make no attempts
ters given by (13) and (15). We use the methodology suggested by Piter- to smooth our calibrated parameters in the time dimension. The calibra-
barg (2005a-b). The exact details are quite complicated and are omitted tion takes about five seconds of computer time.

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## WWW.RISK.NET ● SEPTEMBER 2005 RISK 107

Cutting edge l Interest rates

## B. Parameters of a calibrated four- 4. Total calibration error

factor model
1.0
t λ1(t) λ2(t) λ3(t) λ4(t) m1(t) m2(t) m3(t) m4(t) ε(t)
0.5 0.2120 0.2452 0.1063 0.0907 0.74 0.47 –0.28 –0.44 1.22 0.8
1 0.2242 0.2198 0.1262 0.1017 0.82 0.32 –0.05 –0.56 0.97
0.6
2 0.2266 0.2038 0.1325 0.0992 0.92 0.33 –0.01 –0.74 0.95
3 0.2464 0.1869 0.1336 0.0873 0.89 0.30 0.01 –1.01 0.80 0.4
4 0.2602 0.1906 0.1276 0.1021 0.89 0.26 0.01 –0.84 0.82
5 0.2693 0.1664 0.1278 0.0784 0.89 0.22 0.05 –1.65 0.75 0.2

%
6 0.2954 0.1678 0.1246 0.0872 0.83 0.24 0.06 –1.10 0.86
0.0
7 0.2798 0.1490 0.1268 0.0805 0.87 0.26 0.08 –1.07 0.85 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
8 0.3064 0.1496 0.1185 0.0635 0.80 0.22 0.10 –1.48 0.85 –0.2
9 0.3078 0.1335 0.1207 0.0482 0.80 0.25 0.11 –1.84 0.84
10 0.3040 0.1183 0.1172 0.0410 0.81 0.25 0.13 –1.88 0.84 –0.4
11 0.2934 0.1162 0.1278 0.0416 0.82 0.26 0.13 –2.01 0.97 –0.6
12 0.2719 0.1148 0.1219 0.0602 0.87 0.26 0.16 –0.99 0.99
13 0.2541 0.0917 0.1276 0.0519 0.90 0.35 0.16 –1.01 1.02 –0.8
14 0.1891 0.0798 0.1236 0.0658 1.40 0.37 0.20 –0.50 1.04
15 0.1574 0.0529 0.1254 0.0707 1.83 0.70 0.20 –0.36 1.06 This figure shows the total calibration error in terms of the Black-
16 0.1671 0.1009 0.1410 0.0695 1.73 0.19 0.20 –1.42 0.94 Scholes volatility when calibrating a four-factor model to the full euro
17 0.1705 0.1013 0.1413 0.0734 1.77 0.35 0.14 –0.89 0.94 market. We depict the difference between the yield curve model and
18 0.1690 0.0893 0.1492 0.0623 1.97 0.45 0.12 –1.01 0.94 the target when we price caps and swaptions by simulation. 131,072
20 0.1147 0.0768 0.1554 0.0631 2.03 1.70 –0.11 0.39 0.94 simulations were used, making the simulation error roughly of the
order of 0.10% in terms of implied Black-Scholes volatility. Expiries
Note: this table reports the resulting parameters when calibrating a four- range from six months to 20 years, tenors range from six months to
factor model to the euro swaption and cap data of table A 30 years and strikes range from 5–95% Black-Scholes delta – all in
all 1,024 caplets and swaptions

## 3. Pure calibration error C. CPU times for simulation in LMM and in

separable HJM
0.8
Maturity LMM HJM
0.6 5y 2.12 1.14
10y 7.20 2.22
0.4 15y 15.19 3.33
0.2 20y 26.21 4.46
25y 40.27 5.53
0.0 30y 55.13 6.56
%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
–0.2
Note: CPU times in seconds for simulation of 5y, … , 30y vanilla interest
–0.4 rate swaps with monthly reset in a four-factor Libor market model and our
four-factor separable volatility structure HJM model
–0.6
–0.8
–1.0 4. We see that the total calibration error is within +/-0.40% in Black-Sc-
holes volatility terms in most of the range.
This figure shows the pure calibration error in terms of implied Black- In summary, a four-factor version of the model can simultaneously fit
Scholes volatility when calibrating a four-factor model to the full euro market prices of caps and swaptions for all strikes (5–95% delta), expiries
cap and swaption market. We depict the difference between the yield
curve model and the target when we price caps and swaptions under
(six months to 20 years), and tenors (six months to 30 years), within a tol-
our approximations A and B. Expiries range from six months to 20 erance of 0.4% in implied Black volatility terms. Moreover, the calibration
years, tenors from six months to 30 years and strikes from 5–95% in only takes about five seconds of computer time.
terms of Black-Scholes delta – all in all 1,024 caplets and swaptions
Monte Carlo simulation
Strictly speaking, stochastic differential equations of the type defined by
The error of such a calibration can be split in two. First, there is the error (3) and (7) can in some cases exhibit explosive behaviour. To avoid this
from the fact that a four-factor model will not be able to exactly match the problem, we follow Heath, Jarrow & Morton (1992) and simply replace f(t,
smiles of eight tenors. We show this error by pricing swaptions and caps t + τi) in (7) with:
for all the calibration expiries and tenors by use of the approximation A
and B, and comparing the resulting prices to those of the target model. The ( (
f (t , t + τi ) = max f (0, t + τi ) − c, min f (t , t + τi ) , f (0, t + τi ) + c )) (16)
strikes chosen correspond to 5–95% delta in Black-Scholes terms. In all, we
price 1,024 caplets and swaptions. We call this error ‘pure calibration error’ where c is some constant.
and it is shown in figure 3. We see that the pure calibration error is within Due to the fact that the natural domain for the stochastic volatility fac-
+/–0.25% in Black-Scholes volatility terms in most of the range. tor z is {z ≥ 0}, straightforward Euler discretisation of the stochastic dif-
What actually counts, however, is of course what the error is when the ferential equation for z is going to exhibit very poor convergence as we
model is simulated. We call this “total calibration error” and the result of decrease the time steps ∆t → 0. Instead, we prefer to use the following
pricing up all the calibration swaptions by simulation is shown in Figure (local) lognormal discretisation:

## 108 RISK SEPTEMBER 2005 ● WWW.RISK.NET

− 12 v 2 + vN (0,1)
z (t + ∆t ) = ze REFERENCES
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
(
 2β
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1 − e −β∆t +
ε2
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We combine this with standard Euler discretisation of X, Y. With typical Applied Stochastic Models and Data Analysis 1, pages 49–62
Cheyette O, 1992
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also with four factors. The resulting computer times are reported in table contingent claims valuation
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Jamshidian F, 1991
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Finite difference solution Lewis A, 2000
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Risk February, pages 61–65
∂V
0= +  Dx + Dy + Dz  V Mitchell A and D Griffiths, 1980
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1 1   2  1 1  Vasicek O, 1977
 ∆t − 2 Dx  V  t + 3 ∆t  =  ∆t + 2 Dx + Dy + Dz  V (t + ∆t ) An equilibrium characterization of the term structure
    Journal of Financial Economics 5, pages 177–188
1 1   1  1  2  1
 ∆t − 2 Dy  V  t + 3 ∆t  = ∆t V  t + 3 ∆t  − 2 DyV (t + ∆t )
  (17)
1 1  1  1  1 but this does not seem to be a problem in practice.
 ∆t − 2 Dz  V (t ) = ∆t V  t + 3 ∆t  − 2 DzV (t + ∆t ) In summary, we have a scheme with the following properties:
 
■ Uniform von Neuman stability.
where V(t) is to be interpreted as a three-dimensional tensor of values at ■ Accuracy of O(∆t2 + ∆x2 + ∆y4 + ∆zp), p < 2.
time t. ■ Workload of O(∆t–1 × ∆x–1 × ∆y–q × ∆z–1), q > 1.
We use the standard three-point discretisation for Dx and Dz, but for In practice, a 30-year Bermuda swaption is accurately priced on a grid of
Dy we use a five-point discretisation for the first derivative. This gives high- dimension 50 × 100 × 10 × 15 (t × x × y × z) steps and this takes about
er accuracy in the y dimension, O(∆y4), and enables us to get away with three seconds of computer time.
relatively few y steps, say 10. The disadvantage of the five-point discreti-
sation is that the workload increases at a rate higher than the O(∆y–1) of Conclusion
a three-point scheme but we find that is worth it in this particular case. We have presented a class of stochastic volatility yield curve models with
Square-root processes such as (7b), with high volatility and low mean quick and accurate calibration and significantly quicker Monte Carlo sim-
reversion and therefore high probability of hitting z = 0 can be tricky to ulation than general HJM or Libor market models. A one-factor version of
solve numerically. Linear discretisation of the z axis according to the stan- the model can be implemented with a finite difference solution and can
dard deviation of z at maturity leads to very few points in the interval [0, thus be used as an alternative to the standard one-factor models for day-
1] relative to the number of points between one and the upper bound of to-day management of large portfolios of interest rate exotics. ■
z. Attempting to solve this problem by transforming the state variable in-
troduces infinite drift for the transformed variable at z = 0 and this is there- Jesper Andreasen is a principal in the fixed income quantitative
fore not a recommendable route. Instead we choose to discretise z according research group at Bank of America in London. Email:
to zj O(j2). This means that we get lower asymptotic accuracy than O(∆z2) jesper.andreasen@bankofamerica.com